POLARIS INFRASTRUCTURE;

RAMPF-OTC, PIF:TSX

COMPANY ANALYSIS – SEPTEMBER 23, 2016

 

In August 2016, Polaris hit a HUGE well at its geothermal plant in Nicaragua, which will drive cash flow, dividends, and the share price higher.

Earlier in 2016, management started a dividend of US $0.10 per quarter.  But I think that has the potential to increase 200-300% over the coming 3-4 years—and I explain how that could be—in my report below. (I expect the first dividend increase very soon, and I expect it to be a BIG ONE—likely a double of existing dividend.  Math below.)

I travelled to Nicaragua and visited the plant.  I’ve met management several times, and spent a lot of time talking to analysts and fund managers about the company.

Polaris is the best green energy company I see anywhere in the world today.  Its recent (very) successful drill program has taken all the technical risk out of the play.  It does not need subsidies.  Politics favour the company–Nicaragua NEEDS this power, and Nicaragua needs to show the world they can do business.  And dividend increases are coming—I think in a BIG way.

In fact, here’s a long list that I like about Polaris:

  • Few shares outstanding (15.7 million). This = LEVERAGE.
  • Generating not just positive but FREE cash flow
  • (VERY) Low decline production
  • Known selling price for their power through 2029
  • Opportunity to refinance expensive subordinated debt
  • Risk of exploration drilling is behind them
  • Low risk opportunity to expand production with no exploration risk
  • Attractive valuation
  • Growing need for renewable energy in its country of operation
  • Likely dividend increase coming

That is a long list.

When I found this company, it was about to drill three new production wells.   Each of those wells carried a lot of risk.  In geothermal drilling, results are really unpredictable.

The results are now in and they are good.

While the share price has risen as a result of those wells (from CAD$7-$18), the valuation here is still very attractive and the risk level greatly reduced.

QUICK FACTS (In U.S. Dollars)

Trading Symbols:                                            RPG-TSX, RAMPF-OTC

Share Price Today:                                          $13.79 (OTC price)

TSX price (Cdn $$)                                     $18.00

Basic Shares Outstanding:                               15.7 million

Market Cap:                                                     $216.5 million

Net Debt:                                                         $150.0 million

Enterprise Value (EV):                                    $366.5 million

Estimated Q4 2016 annualized EBITDA :         $54.0 million

Current Annualized Dividend:                        $0.40 (2.9% yield)

Note: Financials and stock price above are in U.S. dollars

POSITIVES

– Valued at a much lower multiple than similar companies

– Nicaragua needs more electric power and is committed to renewable energy

– This asset is a flagship for the country so it will get government support

– Wells have very low decline rates, allows for BIG free cash flow

– Clear visibility for continued production and cash flow growth

– Likely to see a dividend increase (or three or four)

NEGATIVES

– it’s a one asset company in a leftist, Central American country

– Yeah, that’s about it

BACKGROUND/PROPERTIES

Polaris was previously called Ram Power—which went bankrupt. In 2015 Ram Power Corporation went through a balance sheet recapitalization and a makeover at both the Board and management level.

The recapitalization involved $54.6 million (Canadian) of secured debt being exchanged for 5.5 million common shares and another 9.25 million shares being issued for $74 million (Canadian) in cash.  After the recapitalization the newly issued shares accounted for 60% of the total outstanding and the converted debtholders who are now shareholders another 35%.  Prior shareholders were left with 5%.

I should note that Ram’s problems were due mainly to the balance sheet that the company chose to operate with.  The operating assets of the company were—and still are—quite attractive.  Too much leverage, some development hiccups, and cost overruns—pushed Ram to the brink.

Former shareholders are not left with fond memories of their experience with this company.  For those of us looking at the company for the first time we found a new name (Polaris Infrastructure) new Board of Directors and management, a cleaned up balance sheet and an appealing valuation.

Polaris is in the renewable energy business with an operational geothermal project in Northwest Nicaragua.  Geothermal power is a clean and renewable energy source where the Earth’s heat produces molten rock which warms underground water.

Geothermal is different from all renewables in that it is considered baseload power—it doesn’t turn off—ever.  That makes it special.

Wells are then drilled to bring the superheated water and steam to the surface which drives turbines that generate electricity.  The water (or brine at this point) are then re-injected underground to replenish the reservoir and thus making the geothermal energy source renewable.

For more information on the process read my recap of my visit to the company’s plant in February 2016 later in this report.

San Jacinto

Polaris’ primary asset is its San Jacinto project, a 72Mw project covering 40 square kilometers in northwest Nicaragua.

Production from Jacinto has been very steady for the last several years within a band ranging from 47.9 Mw to 49.5 Mw.  Without any downtime production would have been at 54 Mw.

All of this production was from just eight wells.  Production varied a lot among the the wells (which is normal), ranging from 14Mw to 2Mw, with an average of 6.19Mw per well on a net basis (~7Mw gross).

That is a big challenge of this business.  You don’t really know what you are going to get when you drill a well.  And since there are only eight of them in total each well is a real “hold your breath” kind of moment when it is initially drilled.

But the enjoyable part is that these wells decline extremely slowly, especially with water reinjection wells like Polaris has.

This isn’t like shale production where as soon as you drill a well you need to get started on the next one to offset production declines. Current production is declining at only 3% per year.

That means that geothermal production generates a much more stable cash flow base.  Each individual well is high-risk up front, but once on production the production base is a much better cash generating engine.  There isn’t the need to frantically keep spending money on new wells to offset production declines.

That allows for free cash flow to be, folks—cash that doesn’t have to be reinvested to just keep production flat.

Production  from  San  Jacinto is  sold  under  a  long-term  power  purchase  agreement with Disnorte-Dissur which is the operator of the Nicaraguan electricity distribution system.  Disnorte-Dissur is 16% owned by the Government of Nicaragua with the rest of the company in the hands of Spanish utility TSK Melfosur.   Under the agreement, Disnorte-Dissur is required to purchase all electricity from San Jacinto through 2029.  The current purchase price in 2015 is $115 per MWh with an annual escalation of 3% through 2022 and 1.5% thereafter.

So this is another attractive part of the Polaris business.   The selling price is known and you have a committed customer.  Combine that with low decline production and cash flow is very solid.

Nicaragua is growing its economy at 4.4% per annum (one of the best growth rates in South/Central America). Usually electricity usage growth occurs at a multiple of GDP growth as electricity usage intensifies per capita so there should be no concerns about demand for the electricity Polaris generates.

Today Nicaragua is still burning bunker fuel (dirtiest but cheapest oil there is) for about 45% of their electricity production.  At current growth rates Nicaragua is going to need 50% more electricity in 10 years…..you can bet they aren’t going to be wanting that to come from bunker fuel.

Nicaragua wouldn’t be first on my list of countries in which to invest.  It has a history colored with dictatorship, violence and problems.  This isn’t unique in Central America.

Daniel Ortega has been Nicaragua’s president since 2007.  He is a socialist and under his leadership Nicaragua’s constitution has been amended to allow for an unlimited number of 5-year presidential terms.

He is essentially a dictator so anything is possible.

That said the nationalization of companies in Nicaragua which was common in the 1980s has ceased.  Nicaragua allows for 100% foreign ownership in most sectors and allows for the repatriation of profits.

Twenty-five percent of Nicaragua’s population currently has no access to the electric grid.  Rectifying that is a key goal for the Ortega government.  That is good for Polaris, as is the fact that the government has a stated goal of generating 90% of its power from renewables by 2020.

Without foreign capital none of those goals can be achieved, so the Ortega government does have to treat foreign companies fairly.  The country needs foreign capital flowing in.

The Polaris San Jacinto project has been viewed as a showcase project for Nicaragua.  It is one of the largest foreign investments in energy in Nicaragua and the government is proud to share that fact.

After getting its balance sheet fixed up last year, 2016 has been a busy one for Polaris.

Polaris went into the year with only 8 producing wells.  The plan for 2016 was to drill three more.  The company has done that, with the last one completed on July 21, 2016.

The slide above shows the expected power contribution from each of these three wells now that results are known.  Note again the wide range in what each is going to contribute…..Polaris had no idea what each of these wells would be capable of before drilling.

It could have been from virtually nothing to up to 12-14 MW per day.  One spectacular success, one so-so and one disaster.  All together the result of these three wells is very good.

These wells together will bring the Polaris base company production rate up from 50 MW to 64 MW.   The 9-4 well is actually currently producing at 15 to 17 MW in September which is a lot higher than the 10 to 12 MW expected…..but we don’t know if that will hold so I’m taking the expected 10-12 MW level.

Either way, the combined drilling results for 2016 are good and will add 12 to 16 MW.

The next possible production growth could come from constructing a binary geothermal unit. That would be on-site and would add another 6 to 10 MW of production without taking on any exploration risk.

The binary plant offers an opportunity to re-use the geothermal water by having it heat a second liquid that boils at a lower temperature than water.

How it works is the geothermal water first creates electric power through the existing plant where steam turns turbines which power generators.  Then that geothermal water which has now cooled somewhat is used to heat the second liquid to a boil which offers the same turbine turning power generation.

The second liquid with the lower boiling point could be isobutene or pentafluorpropane……or so Google tells me.

The downside is that the construction is rather expensive—about $25 million in worst case scenario—though that’s only a 4 year payback on an asset that will last 50 years. Binary units are low tech and close to “off-the-shelf” technology; many are in use around the world.

EVEN MORE LONGER TERM GROWTH…

Beyond the binary unit construction, Polaris has a second project that is a few years out yet.  The Casita project which is located in northwest Nicaragua in the Department of Chinandega. In 2008, through an international bid, Cerro Colorado Power, S.A., a 95% owned subsidiary of Polaris Infrastructure, was awarded the Casita Project Exploration Concession with an area of 100 km2.

In July 2011, the Company commenced drilling of the first slim hole well was drilled to a depth of 842 meters with a total loss of circulation of the drilling fluid.  THAT’S A GOOD THING!

If you lose fluid, it means you’ve hit a permeable hotspot where the geothermal heat can come up a well bore.

The temperature results obtained and the permeability found to date indicate that the location has the characteristics of a commercial resource, and this information was used in converting the exploration concession to an exploitation concession from the Nicaraguan Ministry of Energy and Mines.

In February 2013, the Company was awarded the exploitation concession for a period of 25 years (extended by law in 2014 to 30 years) and was provided a timetable to sign the formal contract, which the Company is currently in the process of negotiating and expects to finalize in 2017.

Casita could add significant growth, but it also adds a lot more risk than what we currently have which is predictable cash flow through a very low decline geothermal production.

Alternatively Polaris could become a consolidator of assets within Nicaragua.

With a stable cash flow base Polaris could take advantage of the lack of competition for renewable projects in North America.  The company has identified numerous smallish 25 plus MW projects in the region.

 

 

FINANCES / VALUATION

For the first six months of 2016 Polaris EBITDA was in the $10 million per quarter range –$40 million annualized.

With the new wells coming on production each additional MW will provide roughly US$1million of EBITDA, virtually all of which will add to current free cash flow since maintenance capital requirements are so low.

With the 14 MW (maybe more) from the new wells that should take EBITDA from US$40 million to US$54 million.

Similar companies in the renewable energy sector currently trade at a forward EBITDA multiple of 11.5.   Apply that multiple to Polaris and you get an enterprise value of US$621 million.

Back out the net debt of US$150 million and you get a valuation of:

$621 million less $150 million = $471 million / 15.7 mil shares = US$30

That renewable energy multiple might be overly optimistic for Polaris though.  The company is small, Nicaragua deserves a bit of a discount.  If I change the multiple to 9 times I still get to US$21.40 per share.

That is a nice premium to the current share price.

What I really like is that Polaris thinks that it needs to spend about $5 to 6 million every year to maintain production at current levels.  That isn’t very much and means that there is a lot of free cash flow here–free cash flow that can be used to increase the dividend, make acquisitions, pay down debt or fund the binary unit expansion.

 

DIVIDEND INCREASES COMING…

Because so much of their costs are fixed and the decline rate is so low, any extra revenue basically becomes EBITDA and FCF—Free Cash Flow—almost immediately.

The extra $14 million in EBITDA that Polaris will start generating very quickly will almost certainly be used to increase the dividend.  The question is…how much?

Management has said that for now they want to see dividends at 50% of cash flow, but could see that rising to 60%.  At 50%, that would mean an extra US$7 million in dividends over 15.7 million shares, or 44 cents per share.  Add that to the 40 cents per share now and it’s a total of US$0.84/share dividend that should happen within the next 1-2 quarters (writing as of Oct 2016).  That’s a 6.3% yield on the price of $13.19 at time of writing.

For Canadians, multiply that 84 cents x 1.25 for the lower Canadian dollar and you get a dividend of $1.05, which on an $18 stock works out to a yield of 5.8%. (But if you bought the stock when I did at $7, it would be 15%–that’s why you should be a subscriber!)

More FCF is possible—the (at most) $25 million binary unit will add let’s say US$8 million of cash flow from 8 MW (6-10 range), which would add $4 million or 24 cents per share to the dividend within 2-3 years.

Refinancing the World Bank debt to shave 2 points off interest could add $3-$5 million FCF, and if $1.5 million of that flowed to dividends then there’s another 10 cents per share.

The point is—the likelihood of steady dividend increases over the next three years is high.

At June 30, 2016 Polaris had $47 million of cash and $185 million of long term debt ($9.9 million due within one year).

The senior debt carries an interest rate of 6.5% which can be reduced over the next 3 years by 1.5% per year if the company hits production targets of 58 Mw by May 2017, 55.1 Mw by May 2018 and 52.3 Mw by May 2019.

The subordinated debt has a fixed interest rate of 6% plus 3% of annual EBITDA for the prior three quarters but capped at 13%.  That is expensive debt and something that the company could replace and save a significant amount of interest.

Replacing that $30 million of subordinated debt with something at the 6.5% rate of the senior debt would shave $2 million of interest expensive.

MY VISIT TO THE POLARIS GEOTHERMAL PLANT – MARCH 2016

When I was first researching Polaris I called up the company and asked if I could come take a look at operations.  A few days later I was on a plane to Nicaragua!  At this point test results on only one of the three 2016 wells was known.

I had a great trip; CEO Marc Murnaghan made the senior operational staff available to us for hours at a time to ask whatever we wanted.

I was there for a couple days, and on the day we visited the geothermal plant itself everyone got up early and was on the bus by 7 am. We left our hotel in the center of Managua and were driven up into the hills and around the north side of Lake Xolotlan.

It was a gorgeous sunny morning, and the countryside was greener and more prosperous—crop farming, fallow but tilled land; than our previous day’s excursion to the south of Managua.

Heading north, there were fewer tin shacks along the side of the Pan-American Highway; the adobe or brick homes were mostly painted as well.  And there was new pavement.

The Pan-American Highway is just two lanes, and it can take a long time to pass.  You can’t be in a hurry.  The highway goes all the way to Chile now.  Nicaragua is considered one of the safest places in Central America, but our tour bus was stopped by police and asked for our tourist permit.

There is no such thing as a tourist permit.  Our guide got out and had a chat with the two armed policemen there and we were on our way in a couple minutes.  I’m not so sure how easy that would have been if it was just me and my blond family in sedan with Google maps.

The small town of San Jacinto, where the geothermal plant is located, is just the other side of the most active volcano in Nicaragua, Cerro Negro.  There was some volcanic steam coming out of the top as we drove right by it.

San Jacinto is a couple secondary roads away from the Pan-American Highway and those roads also had new pavement, and wide traffic circles.  It was still common to see horse and carriages and three wheel little vehicles—they were called tuktuks when I was backpacking in Thailand 20 years ago.

We turned off the pavement into the gravel driveway that led back to the plant, and when we got out of the van we were hit with our first big heat of the trip; all 12 of the pasty white Canadians jumped out and it was 33 degrees in the gravel and steel compound.

All the senior Nicaraguan staff was there, and they, along with CEO Marc Murnaghan, gave us a detailed, hour long presentation on the technical details of the plant.  Murnaghan is clearly proud of his team, and he made them available to us at several points throughout the trip to ask whatever questions we wanted.

I wanted to know if the reservoir was heating back up at a normal rate, or if it was slower than normal; this first well has taken much longer than management’s guidance last fall.  Originally they thought they would have results by late December 2015.

But the drilling of the well took longer than expected, which means that they had to inject a lot more cold water into the reservoir than expected.  You need 235 degrees Celsius in the geothermal reservoir to continually and reliably keep sending steam and hot brine up the well bore.

The cold water—which cools the drill bit and recirculates the drill cuttings back up to the surface (like any normal oil and gas well)—took the reservoir temperature all the way down to 60 degrees, and on Monday February 29th it was 162 degrees, and going up by about 2 degrees every day.

Once the magic 235 degree mark is attained for a few days, they start a 30 day production test at the end of that (now forecast for late April) they will know how many Megawatts (MW) that well will produce.  Rough consensus is 2-4 MW.  Management has already guided that it won’t be a boomer, but not a duster either.

The geothermal zone they target is a big cube that’s 2 km x 2 km x 2 km.  There are three active “producing” zones—shallow, intermediate and deep.  Each of the zones has productive wells.  They are not homogeneous zones; faults create many small pockets of higher and lower permeability within that 8 km cube.  The big wells come from the more permeable zones.

The power plant itself is immaculate; we could eat off the floor.  They do keep the plant very clean; it was probably just polished up a bit for us.

After the presentation, we donned our hardhats and neon yellow mesh vests—in case we hopped the 10 foot fence and got lost somewhere out in the desert scrub that you can see for miles—and walked over to the power plant itself.

Remember there are 8 producing geothermal wells here bringing steam and hot brine up from deep underground, and 4 injection wells around them that send water back down to keep the pressure up in the reservoir.  Each of those wells has pipes going to or from the power plant.  That makes for A LOT of pipes in the area.

The incoming pipes have what looks like 6 inches of insulation around them, and are enclosed in a bright shiny exterior pipe.  I don’t understand the dynamics of thermal expansion, but because of that the pipes must have some 90 degree turns in them every few hundred meters.  It makes for some oddball looking pipes, but it does make for cool camera shots.

I’ll make this very simple–the steam comes into the plant via these massive shiny pipes, and goes straight to two sets of twin turbines, that are up about 15 feet off the cement floor.

(if I had any formatting skills I would be dangerous)

The plant is very clean, but loud.  The steam gets the turbines moving at about 3600 rpm, and earplugs were definitely required. This facility creates about 58 MW gross and 52 net (with 6 MW being used to power the plant itself).

CEO Marc was quick to point out those were the exact same numbers they first saw 18 months ago when they did their first due diligence tour—telling us there has been no natural decline in production at all in that time.  (As I mentioned in my initial write up, they are creating a sinking fund to drill a $10 million well every three years to keep production constant, basing that on a 3% annual decline.)

The steam then goes out of the plant to a condenser, where the steam turns back into water—but it’s still very hot.  Then it goes underground a few feet to the next building, where it goes up a pipe and comes out as much colder water into a big vat.

(hot water comes out of turbines then cools in condensing units right outside)

(then water is pumped over to cooling towers before being re-injected into ground to keep up reservoir pressure)

After that brief but informative tour, we drove 1 km over to where they are testing the new well.  Every few days now they do a production test.  What they do is let the steam and hot brine come up the well to clean it out.  At the surface it comes out a big cement silo.  It took three men to open the large circular valve wheel. It only took seconds for white steam to come billowing out of the top of this 20 foot silo.

We walked over around the far side of the silo once it had been operating for a few minutes, and one of the bilingual staff (the only Canadians working for the company at all are CEO Marc and CFO Shane Downey in Toronto; everyone else is from Central America) pointed to the waste water pond behind us.

That brown water should be clear when we start real production he told me.  When the brown coloring clears up—like it is at the far side of the pond right now—that tells us we’re only bringing up pure reservoir fluids.

The last test ran for 80 hours before it exhausted itself; each time they do this the reservoir is a little hotter so the tests should last a bit longer.  At 235 degrees, it should just keep going.

I would add here that even though this is Marc’s first CEO role, he is in Nicaragua every month, he is learning Spanish and it’s clear from the local staff the new management team is respected and liked.

Our last stop before going back to Managua was at the drill site for the second well.  It was interesting for me to learn that this well is a 300 meter step-out from the 8 km cube.  Their geological knowledge says that each well has a 300 meter diameter range from which it can keep retaining and generating heat.

When Marc and his team were arranging the recap financing in 2015, the lenders said they had to drill three wells before instituting a dividend.  And they had a say in where those drills would be located.

For me, coming from a mining and oil and gas background, I would have thought the lowest risk wells would have been somewhere inside the 8 km cube.  But the lenders evidently were nervous a new well within the cube would cannibalize existing production, so they wanted a well drilled outside the cube.

This second well is very near Target Depth (TD) of about 2400 meters.  Obviously they are hoping to hit a high permeability zone here, but truthfully nobody has a clue just yet.

There is a (pretty much guaranteed) sign of success where the drillers know they’ve hit something—they track the amount of water going down into the well.  If all of a sudden the amount of water coming back up decreases, that means they are losing water into the formation—they found some permeability and water is escaping into it.

They will likely reach TD on this well by Monday March 7.  If successful, it needs piping installed to get the brine and steam to the plant, so this well will not likely be tied into production until Q4 16 or Q1 17.

There is a bit more (potential) growth here than I realized.  In my initial talks with management, they binary unit they plan on installing within the next two years would increase production by about 10% or realistically around 6 MW on a 60 MW base.  In a presentation at the facility, they said it could be as high as a 10 MW addition.

Also, they are seeing high enough temperatures in one of the injector wells that it is possible they could turn that into a producer within the next couple years.  They have a contract to produce up to 72 MW of power, so they have room to max that out.

But of course, the Market needs to see what levels of production these first 3 wells come in at to get that bullish.

Later that night the Nicaraguan guest of honor at our dinner was head of the country’s business group, Mr. Jose Aguerri, a quasi-government official from Consejo Superior de la Empresa Privada (COSEP), an organization which acts as a liaison between foreign private investors and the government.

He said that the entire federal budget of Nicaragua for the year was $1.5 billion.  One of our attendees on the tour said the city of Toronto’s budget was approaching $13 billion.

Mr. Aguerri said that President Ortega may not be perfect but he does realize how important business is–being creditworthy and attracting foreign investment.  International hotel chains are evident all over Managua, and Walmart and other international brands are readily seen.

The country really only got going again around 2005-2006 after 25 years of civil war. As a result, it has low GDP and low wages–which attracts investment.

 

WHAT THE ANALYSTS SAY

FIRM                                      TARGET PRICE

Mackie                                              $20.00 

STOCK CHART

CONCLUSION

Polaris is a perfectly example of why I feel blessed for what I get to do for a living.

One day I’ve never heard of the company, a couple of weeks later I’m in Nicaragua looking at a really interesting opportunity.

The Big Risk is now behind the company, as the results from the 3 wells are known.  While the stock has run great this year, there is still room for ANOTHER DOUBLE as these wells are brought on stream, the binary unit is installed and the debt is refinanced.  These are all LOW RISK developments.

Now we have stable production, a pretty good balance sheet, at least ONE if not TWO short term dividend increases (IMHO) and an attractive valuation.

Now it is up to management to do smart things with that cash flow going forward.

The first investment is likely to be the binary unit which the company already has enough cash and cash flow to take care of.  Beyond that we will have to wait to see what management decides to take on.

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